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Monday
Oct122015

Director Independence and Reversing Beam v. Stewart (Part 2)

The court in Sanchez reversed because of the failure of the Chancery Court to consider allegations about the lack of director independence collectively rather than in isolation.  See Delaware County Employees v. Sanchez, CA 1932 (Del.  Sept. 24, 2015). In doing so, however, the Court examined the allegations that the director at issue was not independent because of a longstanding personal relationship with the chair of the board.  

The Court had to deal with the analysis in Beam v. Stewart.  In that case, the plaintiff had provided some information from public sources suggesting a personal relationship between a director and Martha Stewart.  The Court was dismissive of the allegations, essentially characterizing them as matters of “structural bias.” 

In Sanchez, the Court described the allegations in Beam as “thin.”     

  • Here, the plaintiffs did not plead the kind of thin social-circle friendship, for want of a better way to put it, which was at issue in Beam.  In that case, we held that allegations that directors “moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as friends,‟ . . . are insufficient, without more, to rebut the presumption of independence.”    

Of course, in Beam, there was also “a Fortune magazine article focusing on the close personal relationships” among the directors, so the allegations were not entirely about weddings or social circles.  

What made the allegations in Sanchez not thin?  Duration, apparently.   

  • When, as here, a plaintiff has pled that a director has been close friends with an interested party for a half century, the plaintiff has pled facts quite different from those at issue in Beam.  Close friendships of that duration are likely considered precious by many people, and are rare.  People drift apart for many reasons, and when a close relationship endures for that long, a pleading stage inference arises that it is important to the parties.  

In other words, the same kind of factors at issue in Beam might be enough if taking place over a long enough time period.  The analysis adopted by the Court in Sanchez is useful because it creates a relatively objective factor for asserting a disqualifying friendship.  But in truth, the length of the friendship is relevant because it suggests something about the nature of the current relationship.  Thus, the focus should be on the current relationship and allegations that success a closeness should be sufficient to get past reasonable doubt at the pleading stage, even without allegations of a five decade duration.  

Friday
Oct092015

Director Independence and Reversing Beam v. Stewart (Part 1)

The Delaware courts are management friendly. Shareholders rarely win.  So when they do, even in circumstances that seem obvious, it is a newsworthy event.  With that intro in mind, we turn to Delaware County Employees v. Sanchez, CA 1932 (Del.  Sept. 24, 2015).  In that case, the court reviewed whether shareholders had alleged facts that created a reasonable doubt as to the director's lack of independence.

Plaintiffs alleged in the complaint that the chairman and director had a close friendship and outside business ties. The complaint alleged a close friendship "for more than five decades." The business ties resulted in allegations that the director's "personal wealth is largely attributable to business interests over which Chairman Sanchez has substantial influence."  The Chancery Court concluded that the allegations were insufficient to show reasonable doubt about the independence of the directors.

The Supreme Court, however, reversed.  Foremost, the Court concluded that the lower court erred by considering the facts separately rather than collectively.  Id.  ("The reason for that is that the Court of Chancery‟s analysis seemed to consider the facts the plaintiffs pled about Jackson‟s personal friendship with Sanchez and the facts they pled regarding his business relationships as entirely separate issues.").  The Court concluded that independence had to be determined "in full context".  As the court reasoned:

  • But in that determination, it is important that the trial court consider all the particularized facts pled by the plaintiffs about the relationships between the director and the interested party in their totality and not in isolation from each other, and draw all reasonable inferences from the totality of those facts in favor of the plaintiffs.  In this case, the plaintiffs pled not only that the director had a close friendship of over half a century with the interested party, but that consistent with that deep friendship, the director‟s primary employment (and that of his brother) was as an executive of a company over which the interested party had substantial influence.  These, and other facts of a similar nature, when taken together, support an inference that the director could not act independently of the interested party. 

The silo nature of independence analysis has been a longstanding characteristic of the Delaware courts. They typically examine each factor individually rather than collectively.  This is particularly true in considering whether payments from the corporation are material.  Take In re Disney, 731 A.2d 342.  Directors were alleged to have received a variety of benefits.  The court examined each one individually, not collectively.  

The court did not consider the fees.  With respect to the legal fees, "Plaintiffs have not indicated that Mitchell, as “special counsel” (and not “partner”) shared in the legal fees paid to his firm." 

Take Mitchell.  In addition to directors fees, he was alleged to have been special counsel at a firm that earned $122,764 for services in 1996.  The plaintiffs also asserted that "Disney paid Mitchell $50,000 for performing these services." 

The court court considered each source of income individually.  Directors fees were not discussed. With respect to the consulting fees, "Plaintiffs have not alleged that the $50,000 in consulting fees was even material to Mitchell".  With respect to the legal fees, "Plaintiffs have not indicated that Mitchell, as “special counsel” (and not “partner”) shared in the legal fees." 

 In other words, the amounts were considered in isolation.  The court never, for example, added the consulting fees to the directors fees to determine if the amount, in the aggregate, was material. After Sanchez, however, it looks as if courts must examine these factors collectively, something that may require that they do the math and add up the amounts when considering materiality.   

Wednesday
Oct072015

Trinity v. Wal-Mart: Banning Shareholders from the Sugar Debate

Trinity v. Wal-Mart is a very poorly reasoned decision.  The court conceded that the shareholder proposal at issue involved matters of important public policy.  Nonetheless, in a made-up test, the court concluded that public policy only trumped the "ordinary business" exclusion of it "transcended" the business of the corporation.

The court gave as an example of its reasoning, the following:  

  • To illustrate the distinction, a proposal that asks a supermarket chain to evaluate its sale of sugary sodas because of the effect on childhood obesity should be excludable because, although the proposal raises a significant social policy issue, the request is too entwined with the fundamentals of the daily activities of a supermarket running its business: deciding which food products will occupy its shelves. 

Coincidentally, the NYT last sunday had an article on this very topic.  See The Decline of Big Soda.  The issue has been much discussed, with consumer behavior changing significantly.  As the article noted: 

  • The drop in soda consumption represents the single largest change in the American diet in the last decade and is responsible for a substantial reduction in the number of daily calories consumed by the average American child. From 2004 to 2012, children consumed 79 fewer sugar-sweetened beverage calories a day, according to a large government survey, representing a 4 percent cut in calories over all. As total calorie intake has declined, obesity rates among school-age children appear to have leveled off.

The issue, therefore, has clear social importance. The majority opinion in Trinity reflects a judicial predilection against the use of the rule to debate matters of public policy that are implicated by the business activities of a public company. To those judges, shareholders ought to have no say in the debate over sugary drinks and obesity. The decision contradicts both the longstanding use of Rule 14a-8 and the growing desire of shareholders to provide advice to companies on matters of important public policy.        

Tuesday
Oct062015

The SEC and Shifting Away from Stats

Professor Urska Velikonja at Emory has written an article that unpacks the enforcement statistics ("stats") annually issued by the Securities and Exchange Commission.  The paper is here.  

That a federal agency would have an incentive to develop a counting system that maximizes numbers is no surprise and I am guessing it is common.  In truth, stats (and their constant increase) have little value except to reduce the inevitable criticism from SEC critics that would occur if the stats dropped.   

Irrespective of how they are counted, the broader issue is whether the SEC should rely on stats as heavily as a measure of success.  In truth, an effective approach to enforcement should involve a certain amount of investigation designed to “look around the corner” and find fraud or misbehavior before it becomes public.  You want to find the Madoff’s before they are on the front page of the Wall Street Journal.  This approach would, by definition, result in investigations that ended without cases being filed.  Under the current system, they would not produce any stats. 

The SEC is presumably heading in this direction.  Nonetheless, the agency is still under pressure to maintain stats.  Hopefully the article will not just encourage a conversation on the best method of calculation but will also encourage a conversation on the need to reduce reliance on this metric as a measure of success.

Monday
Oct052015

Oversight of the Regulatory Function at the NYSE (Part 4)  

The debate notwithstanding, the staff, by delegated authority, approved the NYSE proposals without significant change.  See Exchange Act Release No. 75991 (Sept. 28, 2015).  

The concerns with the structure?  Dismissed.  The reason?  The approach was consistent with other exchanges.  As the staff wrote: 

  • As a preliminary matter, the Commission notes that several concerns raised by the commenter relate to the fact that the Exchange is part of a holding company structure. In that regard, the commenter suggests that the replacement of NYSE Regulation with the ROC would not provide sufficient insulation of the Exchange's regulatory functions from the commercial interests of the holding company. The Commission notes that, although the Exchange may be part of a holding company structure, the Exchange is obligated to satisfy its self-regulatory obligations under the Act and rules and regulations thereunder. The Commission believes that the regulatory structure proposed by the Exchange is consistent with the Act and the rules and regulations thereunder, and is substantially similar to regulatory structures that were approved by the Commission for other exchanges.  

With respect to the lack of authority by the ROC over the regulatory mission of the exchange, the staff did not address the issue in any detail but simply concluded that the NYSE approach was adequate. 

  • The commenter expresses the view that the ROC would not have sufficient substantive authority over the Exchange's regulatory program. In response, the Exchange states that the ROC was modeled on the NASDAQ ROC and has the same powers, including the power to review the regulatory budget and inquire about available regulatory resources. The Commission believes that the Exchange's proposal to establish a ROC, as an independent committee of the Exchange to oversee the adequacy and effectiveness of the Exchange's regulatory operations, should help the Exchange to fulfill its statutory obligation to comply, and to enforce compliance by its members and persons associated with its members, with the Act, the rules and regulations thereunder, and the rules of the Exchange. In addition, the Commission believes that the composition of the ROC, which would consist of at least three members of the Board that satisfy the Company Director Independence Policy, should help ensure the independence of the regulatory function of the ROC. 

The influence of the holding company with respect to the regulatory mission was more or less ignored.  The fact that the structure could have been modestly changed to significantly reduce this potential influence (by for example requiring that a majority of the directors of the ROC not also be directors of the holding company) was ignored.

There is a great ongoing debate about whether exchanges should retain their SRO status.  SIFMA, for example, has criticized the regulatory differences between SROs and ATSs.  Certainly as a matter of optics and likely as a matter of substance, the new structure adopted by the NYSE makes it harder to argue that the regulatory function is anything more than another functional aspect of its business.  The changes add to the weight of those arguing that the NYSE and the other exchanges, as for profit companies, should no longer has any regulatory responsibility.  

For my first letter critiquing the NYSE proposal, go  here.  

Friday
Oct022015

Oversight of the Regulatory Function at the NYSE (Part 3) 

The proposal submitted by the NYSE provided that the board would no longer rely on NYSE Regulation to perform oversight of the regulatory functions of the Exchange.  Instead, the functions would be overseen by a a regulatory oversight committee (ROC) created by the board of the exchange.  Pursuant to delegated authority, the staff approved the revisions

The proposal contemplated that the regulatory function would be overseen by a committee of the board conisting entirely of independent directors (albeit directors who could all serve on the board of the holding company).  Thus, the structure promised some separation between the ROC and the entire board.  Only the actual authority of the ROC, as stated in the proposed language, included no substantive authority except for the power to set goals.  As the proposed amendment provided:  

  • The ROC shall oversee the Company’s regulatory and self-regulatory organization responsibilities and evaluate the adequacy and effectiveness of the Company’s regulatory and self-regulatory organization responsibilities; assess the Company’s regulatory performance; and advise and make recommendations to the Board or other committees of the Board about the Company’s regulatory compliance, effectiveness and plans.  

Thus, the ROC had the authority to oversee, evaulate, assess, advise, and make recommendations. None of this, however provides that the ROC actually has final authority to act.  Instead, final actions are presumably left with the Board of the Exchange, the same Board that could be dominated by directors of the holding company.  

The proposed language to the Operating Agreement also provided that the ROC shall: 

  • (A) review the regulatory budget of the Company and specifically inquire into the adequacy of resources available in the budget for regulatory activities; (B) meet regularly with the Chief Regulatory Officer in executive session; (C) in consultation with the Chief Executive Officer of the Company, establish the goals, assess the performance, and recommend the compensation of the Chief Regulatory Officer; and (D) keep the Board informed with respect to the foregoing.  

Thus the power of the ROC over the budget was to review and inquire but not make final decisions.  The power with respect to the compensation of the Chief Regulatory Officer was to recommend, but only in consultation with the CEO of the Exchange.  

The ROC does, apparently, have the authority to hire and fire the CRO but this was not set out in the proposal. According to the Letter from the NYSE: 

  • Moreover, given that the CRO reports to the ROC, the ROC clearly has the power to retain or dismiss the CRO, only it must do so in consultation with the Exchange’s Chief Executive Officer as part of the process of establishing the goals, assessing the performance, and recommending the CRO’s compensation.  

Thus, even if the ROC consisted of independent directors who were also not directors of the holding company, the final decisions for many functions such as the regulatory budget or the CEO's compensation would be made by the full Board (which could have a supermajority of directors from the holding company) or the CEO (which could have been appointed by a board consiting of a supermajority of directors from the holding company).  

So how did the staff react to the proposal?  That will be in the next post.

The exchange of letters discussing this proposal, including the letter from the NYSE, can be found here.

 

Thursday
Oct012015

Oversight of the Regulatory Function at the NYSE (Part 2)

The proposal submitted by the NYSE provided that the board would no longer rely on NYSE Regulation to perform oversight of the regulatory functions of the Exchange.  Instead, the functions would be overseen by a a regulatory oversight committee (ROC) created by the board of the exchange.  

As proposed, the structure would permit significant potential influence from the holding company.  

First, the ROC is to be appointed by the Board of the Exchange.  There is nothing in the Operating Agreement of the Exchange that prevents the board from being under the control of directors from the holding company. The board of the Exchange must have a majority of independent directors and at least 20% of the directors must be non-affiliated directors (directors who are not members of the board of the holding company).  The operating agreement is here.  Thus, 80% of the board can consist of directors from the holding company.  

Moreover, because the board of the Exchange is only required to have a majority of independent directors, the board can include directors from the holding company who do not meet the independence standards of the Exchange.  

In addition, the ROC itself must consist only of independent directors but nothing in the proposal prevents those directors from also being directors of the holding company, so long as they are independent.  

Thus, under the NYSE proposal, the regulatory function would be under the oversight of a committee appointed by a board that could include a supermajority of directors from the holding company, including at least some directors from the holding company who do not meet the independence standards of the Exchange. The Board would have the authority to designate directors annually and to remove directors at any time "for cause." Finally, the ROC itself could consist of independent directors entirely from the holding company.  

These issues are discussed in an exchange of letters with the NYSE.  The letters are here

Wednesday
Sep302015

Oversight of the Regulatory Function at the NYSE (Part 1)

When the NYSE went public in 2006, a spirited debate arose over whether a for profit company could adequately insulate its regulatory function from the for profit motives of the holding company. 

In seeking to insulate the regulatory function, the NYSE formed NYSE Regulation, a non-profit with a board consisting entirely of independent directors (save only the CEO).  The bylaws provided that NYSE Regulation could not have a majority of directors from the holding company.  In addition, NYSE Regulation had its own compensation and nominating committee, both of which could not have a majority of directors from the holding company.  The Exchange, pursuant to a delegation agreement, assigned regulatory functions to NYSE Regulation (although legal responsibility remained with the Exchange).

Thus, the structure created a number of safeguards designed to separate the regulatory and business functions of the exchange. 

In June 2015, the Exchange proposed to end the structural separation of the regulatory and business function and replace it with a functional separation.  The proposal is here.  

Under the proposal, regulatory authority of the Exchange would no longer be delegated to NYSE Regulation. Instead, the proposal called for the creation of a regulatory oversight committee (ROC) of the board of the exchange and a chief regulatory officer (CRO).  The proposal, however, allowed for greater potential influence from the directors of the for profit holding company than the NYSE Regulation structure.  Moreover, the express language creating the ROC provided the committee with little substantive authority over the regulatory mission of the Exchange.  Despite these concerns, the staff approved the proposal without significant change.  The adopting release is here.  We will discuss these issues in the next few posts.

These issues are discussed in an exchange of letters with the NYSE.  The letters are here.  

Tuesday
Sep292015

Voting Records of SEC Commissioners

The divided nature of the Commission is not news.  At public meetings, more and more decisions are a 3-2 vote.  The public meetings involve only a small percentage for the decisions made by the Commission.  Divided votes at non-public meetings are generally not known. 

One exception concerns decisions resulting in a Commission order.  In those circumstances, the vote is noted by hand in an order maintained by the Commission.  To the extent commissioners dissented, that will be noted on the Order.  To obtain the information, however, it has, in the past, been necessary to examine the Order, something that can be obtained through a FOIA Request.  In other words, the information, unlike a division at a public meeting, was not easily available.

That is no longer the case.  The information can be obtained on line on a page maintained by the SEC that contains "Frequently Requested FOIA Documents."  The page includes a category titled "Final Commissioner Votes" from April 2006 through August 2015. The File includes votes in rules (final and proposed) and orders in administrative proceedings.  The notations note when a particular commissioner is "not participating."  Sometimes the notations state only "Dissapproved."  In those circumstances, the reasons for dissapproval are not apparent.  Commissioners may, however, issue dissents in other forums that disclose the reasons.  Those dissents are not in this file. 

In August 2015, for example, Commissioners Stein and Piwowar "Dissapproved" in In re Citigroup, Securities Act Release No. 9894 (admin proc Aug. 17, 2015) and In re Citigroup, Securities Act Release No. 9896 (admin proc Aug. 19, 2015). The latter is a "waiver release" under the advisers

In July, in connection with Exchange Act Release No. (July 1, 2015), the proposed "clawback rule", Commissioners Gallagher and Piwowar "Dissapproved."  Unlike the Orders, this information is already available in the record of the open meeting that addressed the proposal.  Moreover, the Commissioners both explained the basis for their dissents at he meeting.  (The dissent for Commissioner Gallagher is here and for Commissioner Piwowar here). 

In In re Dickson, Exchange Act Release No. 75418 (admin proc July 9, 2015), the notation in the file states
"Commissioner Gallagher Commissioner Piwowar dissented as to the Municipal Advisor and NRSRO Bars". The same notation appeared on the Order for In re Holdman, Exchange Act Release No. 75462 (admin proc July 15, 2015).  In In re Edwards, Exchange Act Release No. 75563 (admin proc July 30, 2015), Commissioner Piwowar "Disapproved." Interestingly, in this case, two commissioners were listed as "not participating" suggesting that th evote was 2-1. 

Over time, we may explore more of the voting records set out in these files.  Nonetheless, they provide an important source of information on the views of, and the divisions in, the Commission. 

Friday
Sep252015

The Dark Side of the Pools (Part 3)

We are discussing The Dark Side of the Pools, a report on dark pools recently issued by Healthy Markets.

The Health Markets Report recommends a variety of reforms, ranging from regulatory intervention to self help. The most profound suggestion is only tangentially related to Dark Pools.  Investors need the information needed to assess best execution, irrespective of the trading venue.  As the Report notes: 

  • investors also need more and better data about order routing and executions. Investors should be able to quantitatively test the quality of the services available to them. While private industry efforts are currently pushing data availability forward, there have not been any organized, concerted efforts to establish data standards, impose clock synchronization standards, or require brokers to make critical data available to investors. 

Nonetheless, in the absence of this type of information, investors are left with the need to take prudent steps designed to reduce but not eliminate risk.  These include:  

Demanding Better Disclosure. "Investors should demand better public and private disclosures. To the extent possible, these disclosures should be standardized across market venues. Investors need to know how dark pools operate and how their orders are handled. At the same time, investors and regulators need to have high-quality order routing and execution data against which to test brokers’ and venues’ performance."

Mitigating Conflicts of Interest.  "Investors should demand lesser conflicts of interest from dark pools and their operators. Investors should make informed decisions about the risks of interacting with dark pools that have an affiliate trading for profit in the pool, and should determine whether or not those trading operations are adequately disclosed. Even with disclosure, the risk of abuse remains high."

Updating Policies.  "Investors should update and modernize their practices regarding best execution and fiduciary obligations. This is essential for investors to minimize their trading costs and fulfilling their fiduciary obligations to their clients."

Rewarding Less Conflicted Venues. "Over the long term, investors should continue their efforts to promote independent alternative trading venues whose business models are better aligned to protect the interests of their underlying customers. In addition to providing higher quality venues for investors, these efforts may act as a powerful catalyst to drive reforms at other trading venues."

Thursday
Sep242015

The Dark Side of the Pools (Part 2)

We are discussing The Dark Side of the Pools, a report on dark pools recently issued by Healthy Markets.

Dark pools are not regulated exchanges but are regulated under Regulation ATS.  Regulation ATS was adopted in 1998, well before the degree of fragmentation that has occurred in the markets.  As a result, the Regulation was not designed to address many of the problems that have arisen in an era of for profit exchanges, high frequency trader, and a market with 50 or more trading centers.  

Dark pools provide trading centers that do not disclose the "identity of counterparties or display[] specific order information."  The lack of transparency, therefore, has its advantages.  It also, however, had disadvantages. As the Report from Health Markets notes, dark pools confront a common competitive concern.    

  • Increasing their fill rates and executions meant that dark pools had to find counterparties for their resting orders. This task has always been a significant challenge. Simply stated, it is relatively rare that at the exact same time one mutual fund complex wishes to sell one million shares of a particular stock, another institution in the pool will just happen to want the same million shares. Of course, from a trader’s perspective, the longer an order rests in a dark pool, the greater the risk of information leakage and increased opportunity costs.

One way to accomplish this task is to allow high frequency traders into the pool.  The Dark Pools are not, therefore, a collection of like minded institutions looking to make block trades.  Instead, trading patters began to resemble those in the lit markets.  See Healthy Markets Report at 9 ("As high-speed traders entered the pools, trading volumes sky-rocketed, but the characteristics of dark pools changed. Execution sizes came down, . . .  ultimately converging at the same value as on lit markets.").   

In assessing the quality of trades in Dark Pools, institutions can try to engage in self help.  This, according to the Healthy Markets Report, is not easy or, in some cases, possible.   

  • One reason is that most investors lack comprehensive market data against which to compare their trading. In recent months, some firms have sought to quickly fill this need through enhanced analyses by comparing their customers’ information against public market information about executions. Detailed trading analyses are important, but they are also subject to the quality and breadth of information provided, as well as to the technical expertise, biases, and analytical capabilities of providers.
  • These analyses will also take time to complete, and once completed, will likely provide little illumination. Of course, if a venue is shown to perform extremely poorly, then an investor or broker should immediately suspend trading at that venue, and route elsewhere. But if the analysis was already clear-cut enough to make this determination, we suspect that such poor performance would have already been identified and order flow to that venue curtailed. 

So, other than the abandonment of Dark Pools, what can be done? 

Wednesday
Sep232015

The Dark Side of the Pools (Part 1)

Market structure remains a significant issue.  With dark pools, registered exchanges, and internalizers, the number of trading centers has proliferated.  The percentage of trades in the dark markets has increased.  At the same time, the trading in the lit markets has become less centralized, with the NYSE, Bats and Nasdaq each taking about 20% of the market.

Some of the concerns that have arisen are technological. Trading centers can break down, as happened recently at the NYSE. But as Healthy Markets ("a not-for-profit association of institutional investors working together with other market participants to promote data-driven reforms to market structure challenges") recently highlighted in a report, The Dark Side of the Pools, substantial concern remains with the lack of transparency in the dark markets.  

Trading in the dark markets has increased significantly over the last decade.  As the SEC noted:  "from February 2005 to February 2014, the collective share of dark venue trading in NYSE stocks increased from 13% to 35%, and the collective share of dark venue trading in NASDAQ stocks increased from 29% to 39%."

Despite the ominous sounding name (perhaps dark pools as a group should put in for a name change), the growth reflects market demand.  As the Healthy Markets Report noted: 

  • For institutional investors, the need for dark pools has never been greater. High-speed traders armed with cutting-edge technology have grown stunningly adept at identifying, exploiting, and profiting from large orders. To gain even more of an edge, some of these high-speed traders have been awarded special—and sometimes secret—privileges from market centers, such as greater or faster access to information, or specialized order types.

Yet despite this demand, concern continues over the practices of dark pools.  Many are chronicled in the review by Healthy Markets of the recent cases brought by the SEC (against Pipeline, UBS and ITG) and the NY AG (Barclays and Credit Suisse).  We will discuss some of these concerns in the next several posts. 

Tuesday
Sep222015

Espinoza v. Dimon: Helping the Hapless Second Circuit

The Second Circuit certified the following question to the Delaware Supreme Court: 

  • If a shareholder demands that a board of directors investigate both an underlying wrongdoing and subsequent misstatements by corporate officers about that wrongdoing, what factors should a court consider in deciding whether the board acted in a grossly negligent fashion by focusing its investigation solely on the underlying wrongdoing? 

The Delaware Supreme Court was more than happy to help the hapless Second Circuit deal with such a basic question. 

  • We appreciate our colleagues‘ concern about applying principles of Delaware law with fidelity and their willingness to ask for our input.6 In fact, we were honored to answer two prior requests from our colleagues on the Second Circuit within the past year. In that same spirit, we accept our colleagues‘ current request for certification and we will try to be as helpful as we can, consistent with the careful and precise manner in which the tool of answering certified questions of law should be employed.

Ultimately, the Court rejected the certified question. Id. ("in providing an answer, we feel obliged to decline to answer the question as formulated or to try to reformulate the question more narrowly.").  Nonetheless, the Court was kind enough to provide four or so additional pages providing some "thoughts" on the decision "and an explanation of why we do not go further."  Perhaps with this helpful guidance, the Second Circuit will be able to get the question right the next time around. 

Monday
Sep212015

Trinity v. Wal-Mart Stores: Certiorari Sought

The shareholder in Trinity v. Wal-Mart has filed a petition for cert in connection with the rule of the Third Circuit. The issue, as framed by Trinity:
  • Did the Third Circuit depart from the need for judicial neutrality as to the merit of a shareholder proposal in holding that SEC proxy rules were violated because of what the Court felt was ambiguity in a proposed board committee charter amendment?

The petition, among other things, suggests that the case is an appropriate vehicle for a reexamination of the degree of deference (if any) given to staff interpretation of its own rules.  Several justices on the Court have suggested that this should be reexamined.

We will have the cert petition posted later today at the DU Corporate Governance web site.

Friday
Sep182015

In re Lucia, Exchange Act Release No. 75837 (Sept. 3, 2015): The Appointments Clause Debate Continues

As we have discussed on the Blog, the system of ALJs at the SEC has been under constitutional attack.  The focus has been on whether the designation of ALJs was done in violation of the Appointments Clause of the Constitution.  Under the Appointments Clause, Inferior Officers must be appointed by the President, the Courts of Law, or the Heads of Departments.  

The SEC has staked its defense on the argument that ALJs are not inferior officers.  The Commission has not asserted and indeed has disavowed that the ALJs were appointed by the Commission.  If the agency loses on the inferior officer issue, the system of ALJs is perforce unconstitutional.

The Commission issued its first decision in an administrative law context on the issue In re Lucia.  The outcome was the same.  ALJs are not inferior officers.  As the opinion stated: 

  • The great majority of government personnel are neither principal nor inferior officers, but rather “mere employees” whose appointments are not restricted by the Appointments Clause. It is undisputed that ALJ Elliot was not appointed by the President, the head of a department, or a court of law. Respondents therefore contend that his appointment violates the Appointments Clause because, in their view, he should be deemed an inferior officer. The Division counters that he is an employee and thus there was no violation of the Appointments Clause

The Commission concluded that ALJs are not inferior officers. 

  • we conclude that the mix of duties and powers of our ALJs is similar in all material respects to the duties and role of the FDIC's ALJs in Landry. Accordingly, we follow Landry, and we conclude that our ALJs are not “inferior officers” under the Appointments Clause

The analysis was repeated in In re Timbervest.  Next stop, the US Court of Appeals.  But the parties get to choose and its likely not to be the DC Circuit where Landry was decided.  See Section 25(a) of the Exchange Act (party may "obtain review of the order in the United States Court of Appeals for the circuit in which he resides or has his principal place of business, or for the District of Columbia Circuit").  The uncertainty as to the constitutionality of the system of ALJ appointments continues.  

Thursday
Sep172015

Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 4)

We are discussing Friedman v. Dolan.

Where does this leave things?  In the court's analysis: 

  • The controlled nature of the company was irrelevant; 
  • The allegation that the family held a majority of the seats on the board and more than 70% of the voting power was irrelevant;   
  • The fact that the total compensation obtained by directors in 2011 was in the vicinity of $200,000 and was irrelevant in determining director independence (see 2012 proxy statement at 48) (similar amounts were provided in 2012 and 2013 and 2014).  
  • The desire to maintain a board position and continue to be paid as a director was deemed irrelevant (the court stated that the fact of compensation was "not enough" to affect independence without bothering to examine whether the amounts were actually material);     
  • The reality that directors on the compensation committee, had they approved less lucrative compensation packages, would have had to interact with the same individuals (and their family members) at subsequent board meetings was irrelevant;   
  • The allegations that one of the family members assisted in "choosing and evaluating the peer group" used by the board in connection with the compensation was irrelevant; 
  • The allegations that the chair of the compensation committee served on the board since 1996, with Charles having been Executive Chairman since 1985 and James a member of the board since 1995 was irrelevant; and 
  • The allegation that the chair of the compensation committee served as a director for MSG, "another company under the Dolan family's control" (and where his brother also worked) was considered irrelevant.

Leave aside that in other countries, the fact that directors are elected by a controlling shareholder matters. Leave aside that, in other countries, the number of years serving on the board matters.  Delaware courts categorically dismiss these factors but have never really explained how these factors are irrelevant to a determination of director independence.  Leave aside that fees paid to directors can be material but that Delaware courts refuse to analyze the materiality of the amount.  And leave aside that the only thing shareholders really asked in this case was to have the compensation reviewed for fairness.    

The ultimate outcome may or may note have been fair to the company.  But certainly, given these allegations, an examine of the fairness of the compensation was in order.  The court, however, examined the allegations individually, as if they stood alone.  A holistic examination of the facts alleged by plaintiff would have dictated more than a court coming away "troubled." It would have dictated an examination of the fairness of the amounts paid.  

In Delaware, compensation need not be fair.  It is enough that there process.  Process in Delaware, however, is a quantitative rather than a qualitative standard.  It is enough that certain boxes are checked.   

Because inadequate process does not guarantee fairness, the system used in Delaware will continue to impose no meaningful restraints on compensation.  If meaningful restraints are to be imposed, they will have to come from the federal government and occur through preemption, a process that SOX and Dodd-Frank have already shown is well underway.      

For primary materials in this case, go to the DU Corporate Governance web site.

Wednesday
Sep162015

Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 3)

We are discussing Friedman v. Dolan, C.A. No. 9425–VCN, June 30, 2015.  

In analyzing the claims against the Compensation Committee, the court noted that the decision was presumptive protected by the business judgment rule.  To survive a motion to dismiss, the plaintiff had to “show either that the “committee that approved the compensation lacked independence (in which case the burden shifts to the defendant director to show that the compensation was objectively reasonable), or to plead facts sufficient to show that the board or committee lacked good faith in making the award.” 

Plaintiffs argued for the “entire fairness” standard given the control of the board by the Dolan family.  The Complaint alleged that the Dolan family consisted of a majority of the board.  The court, however, declined to apply the standard.  

  • the Court hesitates to endorse the principle that every controlled company, regardless of use of an independent committee, must demonstrate the entire fairness of its executive compensation in court whenever questioned by a shareholder. It is especially undesirable to make such a pronouncement here, where annual compensation is not a “transformative” or major decision. In light of Tyson and the nature of executive compensation decisions, the Court will apply the business judgment rule initially. 

Instead, the plaintiff had to demonstrate that the directors on the compensation committee were “beholden to” the controlling party. To do so, the plaintiff must establish that the relationship or tie is material.   

  • The fact of compensation, even from both a parent and a subsidiary company, is not enough. Neither long-term board service nor the mere fact that one was appointed by a controller suffices. Similarly, being retired or having attained a certain age does not cast a reasonable doubt on independence. Close familial ties, such as those between parent and child, can prevent a director from acting independently. Again, the test for independence generally asks whether, based on the alleged conflict, “the director is unable to base his or her decisions on the corporate merits of the issue before the board.”  

Even with these factors ruled out, the plaintiff still alleged that the chair of the compensation committee performed “service at other Dolan-controlled entities” and the fact of “a sibling's employment”.  The court summarily dismissed the allegations. “Unfortunately for Plaintiff, long-term service or relationships, compensation itself, and appointment by a controller do not necessarily rebut the business judgment rule.”  Moreover, “[t]here are no allegations of how [the Chair of the compensation committee’s] decisions were tied to his brother's general employment that would lead the Court to deem his discretion sterilized.”  All of these allegations notwithstanding, the court concluded that “Plaintiff's allegations that the compensation committee could not “say no” are conclusory.”

The plaintiff also raised concern about process. According to the allegations, the compensation committee permited participation by the CEO in setting the compensation.  As the Complaint alleged:    

  • the Compensation Committee reviewed and compared the compensation paid to the CEOs at the Company Peer Group companies when setting James’ compensation. However, as described in the Proxies, the Compensation Committee allowed James to “assist the Compensation Committee and its compensation consultant in determining the Company’s core peer group and the peer group comparisons.” 

The court considered the allegations in the context of bad faith.  They were not enough to establish such a claim.  "A board is not forbidden from seeking management's input in compensation decisions, and the Compensation Committee Defendants retained a compensation consultant.The Court has no reason to believe, from the complaint, that the compensation decisions were uninformed, hastily made, or manipulated by James and Charles." 

Tuesday
Sep152015

Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 2)

We are discussing Friedman v. Dolan.  According to the complaint, a majority of the board of directors of Cablevision consisted of members of the Dolan family.  As the complaint alleged: 

  • Cablevision is controlled by the Dolan family, who collectively hold 72.9% of the total voting power of all the outstanding Cablevision common stock.  Charles F. Dolan (“Charles”), the family’s patriarch, founded Cablevision and has served as the Company’s Executive Chairman since 1985. James L. Dolan (“James”), Charles’ son, has served as Chief Executive Officer (“CEO”) of the Company since 1995 and a director since 1991. Eight other Dolan family members serve on the Board, and along with James and Charles, they constitute a majority of the Board. Cablevision is controlled by the Dolan family, who collectively hold72.9% of the total voting power of all the outstanding Cablevision common stock.Charles F. Dolan (“Charles”), the family’s patriarch, founded Cablevision and hasserved as the Company’s Executive Chairman since 1985. James L. Dolan (“James”),Charles’ son, has served as Chief Executive Officer (“CEO”) of the Company since1995 and a director since 1991. Eight other Dolan family members serve on the Board,and along with James and Charles, they constitute a majority of the Board.

The plaintiff asserted that the company paid an excessive amount of compensation.  As the court described: 

  • The pending litigation asserts claims related to compensation awarded to the Dolan Defendants. From fiscal years 2010 through 2012, Cablevision paid James and Charles compensation worth $41.18 million and $40.27 million, respectively. 12 The executive compensation packages for James and Charles included “a base salary, perquisites, annual cash bonuses, and long-term incentive awards.”13 The perquisites, including a company car and driver and a security program, were valued at $476,000 and $792,000. Also included was a March 2012 “‘special’ one-time grant of stock options,” awarding James and Charles options valued at $6.85 and $7.09 million.

In addition, plaintiff challenged the compensation paid to three members of the Dolan family who served as directors of the company.  

Compensation for non-executive directors was determined by the board.  Compensation for Charles and James was determined by the compensation committee. The compensation committee consisted of three directors characterized by the company as independent. As the plaintiff alleged, the chair of the committee had been a Cablevision director since 1996, had been on the compensation committee since 2004, and served as a director of Madison Square Gardens, "another company under the Dolan family’s control". Moreover, his brother also worked for MSG.   

The court had to determine whether plaintiff sufficiently alleged facts that would be sufficient to get past a motion to dismiss.

Monday
Sep142015

Friedman v. Dolan: Substituting Ineffective Process for Substance (Part 1)

There can’t be a better decision in recent years from the Delaware courts that shows the need for preemption of the standards for determining executive compensation.  The Delaware courts have, for the most part, substituted process for substantive review.  Unfortunately, the courts do not interpret the process in a manner that ensures the fairness of the compensation.  This was made very clear by the decision in Friedman v. Dolan, C.A. No. 9425–VCN, June 30, 2015.  

In Friedman, the Chancery Court described the allegations surrounding compensations this way:  

  • It is hard to look at the facts of this case without going away troubled. A compensation committee with various ties to the controlling shareholder family awarded considerable executive compensation and benefits to the patriarch of that family and his son. Additionally, a board dominated by members of the controlling family approved non-executive director compensation, which accrued to three family-member directors with qualifications and attendance records that have been called into question. 

Expressions of concern or even outrage is never a good sign at the introduction of an opinion.  Thus, after noting these “concerns,” the court had this to say: 

  • Nonetheless, compensation decisions are not the expertise of trial judges, and the Court should not second-guess an independent compensation committee's business decisions that are not irrational. The Court also lacks a principled way to evaluate a director's decision to accept a position and her performance as a director. Although the amount of compensation and board composition raise some concern, that concern does not justify judicial intervention into that thicket here.

We will explore these "concerns" in the next several posts.  

Friday
Sep112015

Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 4)

Is There a Role for Attorneys?

Although crowdfunding is intended to be a simple concept for small businesses and startups in Colorado to raise capital (as described by Representative Lee in his press release issued August 5, 2015), and even though the rules and the forms are written in a step-by-step nature, anticipating that most issuers will proceed without sophisticated legal counsel, there remain sophisticated legal issues that each issuer will have to address. Crowdfunding issuers proceeding without legal counsel will be well-advised to understand the rules and the statute. On-line intermediaries and other advisors need to consider issues surrounding the unauthorized practice of law before assisting prospective issuers in their efforts to comply with the CF Act.

Among the legal questions that issuers and on-line intermediaries will need to address in each crowdfunding offering will be:

  • What is a “single plan of financing” under Rule 147 and how is that interpreted with the limitations of C.R.S. § 11-51-308.5(3)(a)(XI)? Does any prior securities offering by the issuer restrict the issuer’s ability to conduct a crowdfunding offering?
  • Where do the actions of the on-line intermediary become the actions of an unlicensed broker-dealer? Where does the advice provided to the issuer by the on-line intermediary become the unauthorized practice of law?
  • Who drafts the escrow agreement and the agreement with the on-line intermediary, and interprets it for the issuer? This is unlikely to be an off-the-shelf form and will have to be tailored to each issuer, on-line intermediary, and offering.
  • What is “adequate disclosure” for the purposes of Form CF-2?
  • What level of due diligence and documentation will be sufficient to meet the issuer’s and on-line intermediary’s obligations when determining residency of investors and whether they are accredited?
  • How does the issuer manage the future transferability of the securities issued under the CF Act, and what in fact are the limitations?
  • Does the “reasonable basis” requirement for on-line intermediaries under Rule 3.28.C require that the on-line intermediary take affirmative steps, or does it merely prohibit willful blindness?
  • Does the issuer’s notice to the crowd meet the requirements of being “within Colorado” as defined in Rule 3.24.I?

These legal questions have to be considered based on a specific set of facts—facts that likely change from issuer to issuer, on-line intermediary to on-line intermediary, and offering to offering. Those issuers and on-line intermediaries who proceed without competent legal assistance will be taking risks. Unfortunately, lawyers usually want to be paid whether or not the offering is successful, or even commenced. This may be a significant investment for the prospective crowdfunding issuer.

Another consideration for prospective crowdfunding issuers is how to deal with the resulting investors. Assuming that the crowdfunding offering is successful, the issuer may have several hundred to perhaps several thousand new security holders. The CF Act (C.R.S. § 11-51-308.5(3)(a)(XIII)) requires quarterly reporting to these owners. The larger the number of owners, the more difficult reporting will be. Furthermore, experience in the public company world indicates that these owners will be seeking information from the issuer on a regular basis, lodging complaints where performance is not as expected, and trying to develop a trading market. Each security holder is likely to have a different, personalized agenda that may result in significant management time and expense to resolve.

Thoughts on Crowdfunding in Colorado

If the risks can be managed to the satisfaction of the participants, the CF Act may become an extremely useful tool in capital formation for small businesses. It is new, the rules and the Act itself are untested, and there will undoubtedly be many issues that develop. One of the biggest may be whether any depository institution (defined in C.R.S. § 11-51-101) will be willing to act as an escrow agent in a crowdfunding offering at a reasonable cost, recognizing that many investments are likely to be small—$100 or so per person. In brief discussions with certain local banks, they have expressed reluctance to participate in these untested offerings, even though the CF Act specifically provides (in § 11-51-308.5(3)(a)(IV)(D)) that the escrow agent “does not have any duty or liability, contractual or otherwise, to any purchaser or other person.”

It is likely that crowdfunding offerings will be targeted to affinity groups by the issuers—perhaps a broader version of a “family and friends” private placement. Karl Dakin has written a number of blogs that relate to crowdfunding including one entitled “Characteristics of a Crowd” (May 11, 2015). As Professor Dakin indicates, “any message within a crowdfunding campaign must address the perspective of the investor.” Included in the perspective of the investor is whether the investor is considering investing “pocket change” or an investment that could be characterized as “a major life decision.” As Professor Dakin advises with respect to the issuer’s disclosure and other communications with prospective investors:

Too often, entrepreneurs fail to address the perspectives of the investors. They either assume that all investors are alike or that their deal is so good that all investors will invest. This is not true for classical investments based upon seeking a return on investment. And, it will represent a greater error in thinking with regard to crowdfunding.

As a result, Professor Dakin notes that too many issuers are “looking for money in all the wrong places,” “pitching to the wrong people,” “pitching too early” before the issuer is ready, “not knowing the investor,” and considering “investors as ATMs.”

In his paper Teenage Crowdfunding, Professor Andrew A. Schwartz of the University of Colorado Law School predicts that younger entrepreneurs will take advantage of crowdfunding because of their social media and networking skills. Chris Tyrell of Crowdfund Insider suggests that “Crowdfunding is Changing the Female Entrepreneurial Landscape.” Crowdfunding may in fact become the capital formation tool that the Colorado legislature and the U.S. Congress envisioned, but expectations have to be moderated to fit within reality.

Conclusion

Because of the lesser formality of the crowdfunding process, abuse and fraud are possible. Because of the smaller amounts raised, it is hoped that such abuse will be nominal. Nevertheless, prospective investors and attorneys who advise them must be alert for warning signs. Knowing your principals is your best protection, which is why affinity crowdfunding offerings are more likely to succeed than blind offerings to unknown investors. On the other hand, there has been plenty of affinity fraud in the annals of the Securities and Exchange Commission. (See “Affinity Fraud: How To Avoid Investment Scams That Target Groups” (last visited July 15, 2015)).

Properly used and constructed, however, crowdfunding in Colorado may be a very successful tool for smaller businesses seeking to raise capital within their sphere of influence—customers, clients, vendors, friends, family, and others. Although contemplated in the CF Act, it is unlikely that broker-dealers or sales representatives will be involved in the offerings because of their due diligence obligations under their regulatory rules (and the related cost which would be passed on to the crowdfunding issuer). It is also unlikely that issuers will use sophisticated legal guidance, again because of the cost which can quickly make a smaller offering unaffordable.

The best advice for an issuer looking for a crowdfunding offering is to be familiar with the statute and the rules, and to seek an on-line intermediary that will be competent and provide assistance, not only posting the disclosure, but also ensuring the residency of the investors, the required record keeping, arrangements with an affordable escrow agent, and perhaps providing other help in exchange for the non-percentage based fee. On-line intermediaries that are not broker-dealers are operating in other states that have already authorized crowdfunding; as the CF market develops, on-line intermediaries can be expected to appear in Colorado. This may be sooner; this may be later, and it will depend on the market. There will likely be competent on-line intermediaries, and unfortunately there will likely be incompetent on-line intermediaries; issuers should make all relevant inquiries to be comfortable that they are dealing with the correct on-line intermediary.

Let the offerings roll!

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015

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